SEC Issues Concept Release On Regulation S-K; Part 2
On April 15, 2016, the SEC issued a 341-page concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements in Regulation S-K (“S-K Concept Release”). This blog is the second part discussing that concept release. In Part I, which can be read HERE, I discussed the background and general concepts for which the SEC provides discussion and seeks comment. In this Part II, I will discuss the rules and recommendations made by the SEC and, in particular, those related to the 100, 200, 300, 500 and 700 series of Regulation S-K.
The fundamental tenet of the federal securities laws is defined by one word: disclosure. In fact, the SEC neither reviews nor opines on the merits of any company or transaction, but only upon the appropriate disclosure, including risks, made by that company. However, excessive rote immaterial disclosure can dilute the material important information regarding that particular company and have the unintended consequence of weakening necessary disclosure to potential investors and the public trading markets.
The SEC non-financial disclosure requirements for both registration statements and reports under the Exchange Act of 1934 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) are found in Regulation S-K.
At the highest level, the purpose of disclosure is to provide investors and the marketplace with information needed to make informed investment and voting decisions. As discussed in the S-K Concept Release, proper disclosure “may lead to more accurate share prices, discourage fraud, heighten monitoring of the managers of companies, and increase liquidity.” Further, effective disclosure should “increase the integrity of securities markets, build investor confidence, and support the provision of capital to the market.”
The SEC seeks comment on hundreds of questions from broad conceptual points to specific rule changes. In many cases the SEC indicates that additional disclosure might be necessary on a particular topic. Although disclosure improvement is the goal, that does not necessarily mean less information and, in many cases, may actually mean more information.
Description of Business and Properties
The SEC believes that the information elicited under Item 101 regarding a description of the company’s business and Item 102 related to the company’s materially important physical properties, provides the necessary foundation needed by investors to make investing and voting decisions. This basic information assists in putting other disclosure items into context. The SEC seeks comment on whether Items 101 and 102 should be eliminated or modified and whether new or different disclosure requirements should be added to these Items.
The Concept Release contains detailed discussion of each of the requirements under Items 101 and 102, including prior comments received from the public and SEC views. Currently Item 101 requires a description of the general development of the company’s business over the past 3 years for smaller reporting companies and 5 years for other classes of company, or such shorter period as the company has been in business. Item 102 requires disclosure of the location and general character of plants, mines and other materially important physical properties.
Examples of information required include disclosure of the basic background of the business such as: (i) the year of formation; (ii) type of entity; (iii) nature and results of any bankruptcy, receivership or similar; (iv) nature and result of any material reclassification, merger or consolidation; (v) the acquisition or disposition of any material assets outside the ordinary course of business; and (vi) material changes to the business operations. In addition, Item 101 requires a narrative description of a company’s business, including 13 specific areas as follows: (i) principal products produced and services rendered; (ii) new products or segments; (iii) sources and availability of raw materials; (iv) intellectual property; (v) seasonality of business; (vi) working capital practices; (vii) dependence on certain customers; (viii) dollar amount of backlog orders believed to be firm; (ix) business subject to renegotiation or termination of government contracts; (x) competitive conditions; (xi) company sponsored research and development activities; (xii) compliance with environmental laws; and (xiii) number of employees.
Smaller reporting companies benefit from several other scaled disclosures from the standard requirements, including: (i) elimination of the requirement to discuss seasonality, working capital practices, backlog or government contracts; (ii) names of principal suppliers; (iii) royalty agreements or labor contracts; (iv) need for government approval for products or services; and (v) effects of existing or probable government regulations.
Emerging growth companies must meet all of the standard requirements. Moreover, keeping in line with the concept of materiality, where a smaller reporting company is in a business that makes any of the standard disclosures material to its business, it must include those discussions, even if not technically required. Accordingly, for example, a smaller reporting company in a cannabis-related industry would need to include a discussion on the need for government approval for products and services, and the effects of existing or probable government regulations on its business, even though the scaled disclosure requirements would not otherwise require such discussion.
As with other areas of discussion, the SEC requests comments on the scaled disclosure requirements and whether the current disparities between requirements related to smaller reporting companies and emerging growth companies should be eliminated.
The SEC discusses eliminating redundancies in the 101 and 102 disclosure requirements. In particular there are several categories in Form 8-K that request the same information elicited in Items 101 and 102 and included in all 10-Q’s and 10-K’s. Information on business background is included in the MD&A discussion and in footnotes to financial statements. Redundancies could be eliminated by allowing cross-referencing, including internal hyperlinks. Moreover, the SEC could, and should, distinguish between new registrants disclosing their business background for the first time, and those that are established reporting companies repeating information again and again.
Many of the detailed requirements may not be relevant in today’s business environment, which differs greatly from even twenty years ago. For instance, many businesses no longer have physical locations or corporate headquarters but rather run through virtual offices. For those businesses, providing a detailed discussion of each location (home office…) would not be relevant and rather could diminish the value of the business discussion. Likewise, businesses in today’s world often outsource or hire independent contractors. Consideration should be given to expanding the requirements to include such independent contractors, or eliminate this requirement altogether where it does not add value to the particular business. For example, it may be important to know that certain companies are scaling back on their workforce, while for others, the information is not relevant.
Likewise, Regulation S-K does not currently address the current reliance on web-based and intellectual property-based assets and as such, additional disclosure items may need to be included. Another area that may need increased disclosure relates to international business operations and reliance on non-U.S.-based assets.
Management Discussion and Analysis
Although many aspects of disclosure are important, I believe none are quite as important as the financial information and future prospects. Regulation S-X contains the actual financial statement disclosure requirements, and Item 303 of Regulation S-K contains the narrative discussion requirements related to that financial information. This management, discussion and analysis (“MD&A”) not only delivers an explanation of the financial statements, but provides a unique opportunity in SEC reporting for a company to illustrate its distinctiveness among a sea of other fish.
MD&A is intended to provide a narrative of a company’s financial statements and future prospects through the eyes of management. The Regulation S-K Concept Release clearly shows the SEC propensity for MD&A to use a principles/materiality approach and to steer away from a recitation of the financial statements themselves. The SEC also recognizes the concerns that a company has in presenting forward-looking information, and in particular, 10b-5 liability if the plans do not turn out as disclosed.
In recent years management has used MD&A to not only explain the financial statements prepared in accordance with Regulation S-X, which in turn is based on US GAAP, but rather to explain away those financial statements. Approximately 90% of companies use MD&A to provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number often included by management in MD&A. There has been a rise in recent controversy over the use of these non-GAAP numbers, an in-depth discussion of which will be the topic of a future blog.
However, the short version is that 90% of companies use non-GAAP numbers to explain their financial operations and the SEC is pushing back, making a review of the rules related to non-GAAP use a priority. There are very valid reasons for using non-GAAP numbers, such as EBITDA, which is an established indicator of a company’s performance and ability to meet financial obligations. Likewise, certain non-cash balance sheet items, such as derivative liability related to options, warrants, and other convertible instruments, are confusing and often are never realized in a way that has an actual impact on a company’s performance. However, there can be a slippery slope with a company cherry-picking GAAP and non-GAAP numbers to create a picture of financial stability that may not be accurate. I hope that in reviewing this area, the SEC is not myopically stuck on the purity of its view of GAAP, but considers that if 90% of companies find a need to go outside the rules, perhaps the rules themselves needs some adjustment.
Risk-related disclosures need a thorough review and potential overhaul. Although the SEC has long stated that risk factors should not be boilerplate repetition of items applicable to the market as a whole and not necessarily applicable to a particular company, most companies use boilerplate language. I note that Item 503 contains examples of risks that a company can make related to its offerings, and so, of course, those risks, in boilerplate format, are always included in registration statements and reports.
Currently, risk-related disclosures are currently included in multiple items under Regulation S-K, including Item 503 related to investment risk and Item 305 related to market risk. The focus of the SEC discussion is on aggregating risk information in a more central readable format and improving the content to enhance investors’ ability to evaluate the particular risk factors.
Securities of the Company
Several Items in Regulation S-K address the securities of a company. For example, Item 202 requires a description of the terms and conditions of securities being registered; Item 201 requires disclosure of the number of holders of common securities; Item 701 requires disclosure of sales of unregistered securities and use of proceeds from offerings, and Item 703 requires disclosure of securities re-purchased by a company and its affiliates.
As with other areas, the SEC focuses on whether these disclosures should be modified, increased or eliminated and on the presentation of the information.
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